Basel

Motivation. Basel is an agreement made by a bunch of countries’ (G10) representatives to regulate Investment Banks and insurance companies to prevent them from going Bankrupt.

Framework §

Basel forces banks to measure three risks quantitatively:

1. Credit risk = everything in banking book.
2. Market risk = everything in trading book.
3. Operational risk Using the banks’ positions and how much risk they’re taking, it calculates the amount of liquid assets (=capital) the bank must be holding. This is called: def. Minimum Capital Charge (Basel). Amount of assets a bank must be holding. Has two tiers based on how liquid, how risk-free they are:
4. Tier 1: Shareholder equity + retained ernings. (no other claims)
5. Tier 2: Any other positions. (will be claimed by others in case of bankruptcy)

Methodology §

Credit risk (=banking book) is measured by the Risk-weighted assets (RWA) method

$$\text{RWA}=f\cdot \sum _{\forall i}{\text{(asset value)}}_i\times (\text{riskiness weight}{)}_i$$

where $f=8\%$ in Basel 2.5. To calculate the riskiness weights banks can choose:

1. Standardized Approach (SA): regulation specifies weight values per asset type
2. Internal Models Approach (IMA): banks calculates its own weights, but must consider (1) probability of counterparty default and (2) expected loss in case of default Market risk (=trading book) is measured by either:
3. Risk-wegithed Assets = Standard Approach (SA): same as credit risk, weights also similarly supplied
4. Value-at Risk (VaR) = Internal Models Approach (IMA). Calculates probability that loss over time period $t=(\text{1 day, 10 days})$ is over amount $K$ with probability $x\%$ See Value at Risk
   1. Stressed Var (SVaR), …over time period $t=(\text{12 months during 2008 crisis})$…
   2. Incremental Risk Charge (IRC), default and rating change risk